Monday, December 31, 2007

In what is the largest master planned city anywhere in the world, the New Songdo City is being developed on the western coast of South Korea, 40 miles from Seoul, on 1,500 acres of landfill that just a few years ago was water. The project is being developed by a private entity, New Songdo International City Development, a joint venture of Gale International, based in New York, and Posco Engineering and Construction of South Korea. It is claimed that Songdo will be the first "new" city in the world designed and planned as an international business district, and it could be to northeast Asia what Shanghai is to southeast Asia.

New Songdo will cost an estimated $30 billion to build, atop the $10 billion that the city of Incheon and the Korean government are spending on infrastructure projects. This will make it easily the largest private development project anywhere in the world. New Songdo is expected to open its doors in August 2009, when the first phase of construction, including the bridge and city center, is completed. The project is expected to wrap up by 2015.

The Master Plan, designed by world-renown architects Kohn Pedersen Fox (KPF), contains elements of other landmark cities while creating a new, unique blend - a "Synergy City." Cities like Sydney Venice, Paris, New York and London all have served as blueprints of specialized designs that contributed to Songdo's overall structure. A "Synergy City" is one that contains all of the major functions that are needed to support the needs of those who live and work there.

It will have Venice’s canals, New York’s Central Park, the broad tree-lined boulevards of Paris, the colorful shopping bazaar of Marrakesh, Morocco, the pocket gardens of Savannah, Ga., and an opera house like the one in Sydney, Australia. There will also be a seven-mile bridge that will link New Songdo to Incheon International Airport, off the coast.

Water is recycled city wide, energy produced locally, and the Central Park is planted with low-maintenance native plants and trees. There will also be bicycle paths and pedestrian areas, and 40 percent of the city is reserved for parks and green space. The city's plan includes fifty million square feet of office space - including a landmark 65-story Tower and Convention Center, thirty million square feet of Residential Space, ten million square feet of Retail, five million square feet of Hotel Space and ten million square feet of green space.

The South Korean government has designated the area as a free economic zone, a bilingual city (Korean and English) where foreigners can own land and run schools and hospitals and where companies can get relief from Korean taxes and bureaucracy. It is hoped that Songdo will act as the business hub for multinational companies in Northeast Asia.

Though the financing details of the project are not known, it is likely to be one of the most innovative ever financial structuring. It the latest example of those grandiose development projects that have now become the trademark of East Asia.

Sunday, December 30, 2007

Last week SEBI announced that Real Estate Investment Trusts (REITs) would be permitted in India from early next year. REITs are mutual funds investing in real estate, and whose values are dependent on the values of the property it holds. As per the draft regulations unveiled, the REIT should be in the form of a trust created under the Indian Trusts Act, and the trustees should be either a scheduled bank, trust company of a scheduled bank, public financial institution, insurance company, or a corporate body. Every REIT launched should appoint an independent property valuer who will value all the real estate under the scheme, after field verification. They will all be closed-ended schemes, and will be listed on the stock exchanges.

Apart from giving a big boost to construction activity, broadening the real estate market, and making real estate a more organized business activity, REITs may have two major long term consequences1. It will be a major step in bringing the actual market rates of property in line with the registration basic values. Presently land registrations are done at rates which are much below the actual transaction value. This differential, which comes from and goes into the black economy, is large proportion of the undercover economy. REITs will be a major step in rolling back this market. 2. By listing in the stock exchanges and with valuations reflecting the actual market values, REITs will facilitate market based price discovery for properties and the cost of financing home purchases. Presently there are no means of arriving at the market prices and financing rates.

The Economic Times reports that the introduction of pay-and-view format in China for the English Premier League (EPL) football games, has resulted in a precipitious decline of viewership from 30 million to a mere 20000. The Broadcaster, WinTV, which bought telecast rights to the hitherto free EPL matches for a period of three years, are charging $80 (or 588 yuan) every year for each connection. The huge fall in viewership has not only hit WinTV, but also affected the EPL clubs themselves, who had spent millions in courting the massive Chinese market for EPL merchandise.

This is an excellent example of how monopoly pricing has almost wiped out a very vibrant and huge market. It is also an object lesson for sports administrators across the world to be not blinded by the huge telecast rights offered, which may like the aforementioned example, kill the goose that lays the golden eggs. A sporting event without viewership is something similar to a classroom without students.

There may be lesson to be learned for sports administrators from the example of online newspapers and magazine, which increasingly offer all their content free and rely on online advertisements for revenue. There is a very strong case for adopting a similar model for telecasting sporting events. In any case the proportion of money from viewership susbscription is small when compared to the potential advertisement revenues. As numerous studies have repeatedly shown, the critical determinant in the success of any advertising campaign is to get a captive viewership for the advertisement. It is therefore in the interest of any company to pay more for an advertisement platform that is able to capture a big viewership. Popular team sports are one of the best examples of such platforms. Pay-and-view format defeats this objective.

The case becomes all the more compelling for very popular team sport like cricket in India, Football in China and Europe, Baseball and Basketball in the US.

Friday, December 28, 2007

Behavioural Science teaches us that people suffer from greater aversion to risk than attraction to gains, (Endowment effect) and that differently framed questions on the same issue yield differing responses (Framing bias). Messers Samuel Kahneman and Amos Tversky, won the Nobel Prize in Economics for studying similar behavioural phenomenon, collectively called of cognitive biases, which led to the emergence of behavioural economics. Apart from explaining market aberrations, this field of economic analysis is useful in studying many real world problems.

There is an interesting article in the Guardian, There are no penguins in my garden, which tries to draw lessons from the Endowment effect and framing biases for the environmental movement. Arguing that the multiple messages of the environmentalists tend to get lost if the subject is distant, Steve Martin writes, "Perhaps a more effective alternative might be for the environmentalists to not only point out what stands to be lost thousands of miles away but to also point out what stands to be lost a little closer to home. Ideally it would be something that we already possess."

He writes about the need for more specific formulation of the dangers, "Studies demonstrate people's tendency to try to take action to reduce threats and fears but mostly with one very important exception. When recipients of a fear-producing message are not told of a clear and specific action they can take to reduce the danger, they often block out the message and deny that it applies to them. As a consequence, they may indeed be paralysed into taking no action at all."

Driving home the importance of the endowment effect, he writes, "For messages to have the best chance of being effective it would seem that not only should they be framed in terms of what we stand to lose. That loss should be something we currently possess and should also be accompanied with a clear and specific action we can personally take to avoid such as loss."

It would exert a much greater effect on the audience if the damages caused by climate change were presented in terms of what they would individually and collectively stand to directly gain or lose by way of climate change. Therefore instead of far away issues like disappearing penguins and submerging Maldives, the environmental movement should project losses like the increased electricity bills, forced changes in our food habits and personal lifestyle etc.

A few other real world situations where cognitive biases make some policies, especially on taxation, more effective than certain others:1. Packaging a tax as a specific user charge is easier to sell - Framing effect2. Easier to improve revenues by efficiency improvements rather than raising taxes. But such revenue increases do not get acknowledged as much as that raised by higher taxes, even though the effect of both is the same. 3. Fines are easier to levy and collect than even user charges. Fines have a moral repugnance dimension that makes people more willing to pay. 4. Backload a taxation proposal with higher payments deferred for later years - hyperbolic discounting5. Fines may be more effective in incentivizing contractors than monetary incentives (loss aversion effect) 6. Front loaded revenue contracts are easier to sell than back loaded ones with the same Net Present Value of cash flows7. If the tax collection is non-invasive, it is likely to pass through un-noticed. eg the E-ZPass toll collection in the US.8. Small cess on a reasonably large tax stream is easier to push through, especially if it is directed towards a specific cause.9. How about announcing an increase in a user charge or tax (say water connection charge) by 20%, while simultaneously declaring a 25% concession for those who pay within one month? The negative effect of the increase is often offset by the positive from the concession. 10. Offering a bouquet of public services, with varying rates/user charges, can also help take the sting out of proposals for increases in taxation. A basic minimum of services (stripped down, no frills) can be offered at the lowest rate, and the prices of every additional service can increase progressively.

Wednesday, December 26, 2007

It is estimated that the 5161 Indian cities, housing 30% of its population, would require investments of over $200 bn in urban infrastructure over the next decade. The World Bank estimates that atleast $37 bn is needed over the same period, just to provide safe drinking water and sanitation to our city residents.

Property taxes and assigned revenues (stamp duty, entertainment tax, motor vehicle tax), apart from state grants, form the overwhelmingly major share of municipal finances. These revenues while adequate for financing smaller works, are nowhere large enough to finance capital intensive major infrastructure projects, that will qualitatively improve our cities. The infrastructure investment requirements are so massive that even the larger ULBs will be able to meet their financial needs from internal resources only for a couple of years. Further, such cash flow streams financing them were uncertain and irregular, and often inadequate, thereby resulting in spillovers and cost over-runs. The adhoc nature of such financing also meant that these Projects were not conceived and executed in an integrated manner. It is therefore imperative that our Urban Local Bodies (ULBs) look at raising resources externally to fund its huge requirements.

But there exists serious obstacles to accessing the debt markets and raising private capital. Most ULBs suffer from poor property tax collection efficiency and relatively small property tax base, due to large numbers of un-assessed and under-assessed properties. The over dependence on government grants and assigned revenues, and the uncertainty associated with it given the fiscal imbalances affecting State and Central governments, have lowered their credit worthiness. The absence of proper accounting and financial reporting systems, exacerbates the financial problems by concealing the deep rooted economic and financial inefficiencies and also the potential for improvements.

Infrastructure projects, especially in the urban sector, generally suffer from uncertainty associated with cash flow projections and collection mechanism. Therefore urban infrastructure projects face difficulties in attracting investment from private capital. In fact, there are very few successful examples of private investments or project finance in urban infrastructure.

However, water and sewerage projects have certain inherent characteristics, that make them ideally suited for project finance funding. Both involve massive capital investments, have long operational lives and generate assured and periodic cash flows. Further, typical integrated projects in these sectors have stand alone characteristics, with the project assets being distinct entities, making them eminently suitable for off balance sheet funding.

There are three major credit risks associated with project financing in urban infrastructure projects – cash flow (tariff), collection and coverage risks. It has been observed that 76% of all PPP contracts in water and sanitation sectors have had to be re-negotiated, on average within 1.6 years of signing the contracts. Contracts with price caps on user fees or tariffs are especially vulnerable, as they adversely affect both the regular O&M and system expansion investments. The first risk can be mitigated by direct transfers of the differential between cost recovery and user charges, to the service provider. Collection risk can be substantially mitigated by bundling the collection with some existing revenue stream with robust collection efficiency. Coverage risks can be reduced by lowering access charges and making it mandatory for all citizens to utilize the services.

In both water and sewerage projects, there are two revenue streams - a one time connection charge and monthly tariff. The connection charges are a significant amount, and if appropriately priced, can pay back atleast 30% of the project cost immediately. The monthly tariffs are either metered or a flat rate for water supply and is a flat rate (or a portion of the metered water charge) for each water closet connected to the sewerage system. Except in case of metered water supply connections, flat rate tariffs for both can be bundled together with the Property Tax and collected.

A high collection efficiency (and collection bundled with property tax), high coverage ratio (universal coverage of sewerage), and known revenue streams, help considerably mitigate the credit risk associated with such projects. Further, both the monthly tariffs and more particularly, the connection charges, for both water and sewerage are considerably high enough in many cities, if the coverage is maximized (and this can be achieved), to more than recover the project costs over a period of time. The connection charges and tariff cash flows can be easily escrowed to pay off the debt leveraged. In fact, a very convincing case can be made that these two revenue streams are large enough in most ULBs to pay off the entire project cost over a 15-20 year period.

Some small steps can go a long way towards mitigating the risks associated with financing UGD and water assets. Given the same expenditure on fixed assets, irrespective of the number of connections, economically efficient utilization of the assets requires maximizing the coverage. Lowering connection charges and permitting payments in installments coupled with rationalization of procedures, will help more people access these services. Removing public taps, except in exceptional cases, and disconnecting ground water sources will also help mobilize household water connections. Public awareness campaigns supplemented by judiciously invoking the penal public health provisions, can be effective in ensuring that every household in a street accesses the sewerage service and do not let out their waste water into the storm water drains. Apart from regulatory interventions, all these measures can become successful only with the involvement of local stakeholders like Residents Welfare Associations (RWAs) and people’s representatives.

Construction risks, arising from delays in obtaining clearances, taking possession of site, finalizing tenders, removing encroachments and other unforeseen contingencies results in time spill overs and cost over-runs. This can be avoided by handing over advance possession of work site, appointing professional Project Management Consultants, achieving financial closure before starting work, expediting Government level clearances. These risks need to be appropriately allocated between Government and the contractor.

There have also been examples where the Government or its agencies have assumed the entire construction risk. and transferred only the credit risks to the lender. Another alternative is to complete the project with short term bank loans, which can be raised at lower cost. After the construction is completed and revenues streams established, this loan can be swapped with long term debt. This will ensure that the loan term lender will not have to assume many risks, besides also bringing in some discipline to the ULB's project management systems.

Tuesday, December 25, 2007

At a time when nation states are finding it increasingly difficult to act in concert to address global problems, there was interesting example of united action by a few Central Banks early this month. In what could be the fore runner of many similar events, the Central Banks of America, England, Europe, Canada and Switzerland got together early this month, and announced a joint plan to ease the global liquidity crisis by co-ordinating their different monetary interventions. The central Banks of Japan and Sweden too threw in their support for this Plan.

Given the unwillingness or inability of nation states to bring themselves to agree on important issues of global concern, ranging from climate change to world trade, this was an exceptional achievement. The Bank of England described the efforts as an attempt to "demonstrate that central banks are working together to try to forestall any prospective sharp tightening of credit conditions". In the super sensitive, symbol reading world of financial markets, this was a very important positive signal and calming influence. In many ways the Central Banks rescue Plan was a testimony to what professionaly competent agencies, acting independent of political baggage and compulsions, can achieve.

This unprecedented united action, at the sidelines of the Global Central Bankers meeting in Cape Town, seeks to open alternate avenues for injecting liquidity into the global financial markets, especially the short-term money market, without compromising on the reputations of the borrowers. The inter-bank market has been getting increasingly starved of liquidity, as manifested by the widening spreads between the inter-bank lending rates and the policy rates in the dollar (federal funds rate), euro and sterling markets. In fact, in the US the inter-bank market and the traditional discount window through which the Federal Reserve lends directly to the banks, had effectively dried up. With many banks sitting on a very high proportion of dubious quality and even toxic asset backed securities (ABS) and with no mechanism to detect them, banks have been showing increasing reluctance to lend.

It was in this context that the Central Banks agreed to inject more liquidity by auctioning funds at rates banks are willing to offer. Though banks can borrow on the discount window of the Central Bank, they generally rely on the inter-bank market to raise their temporary fund requirements during normal times. Approaching the traditional discount window of borrowing identifies the borrowing bank, and exposes them before the market as being vunerable. At a time when rumours can fly in all directions, this has the potential to create a run on the bank. Auctions, in contrast, keeps out the identity of individual banks and also helps many banks borrow at the same time.

The Fed went further and introduced an exclusive Term Auction Facility (TAF), through which all banks eligible to borrow from the discount window could bid for short term, one-month money. With collaterals declining in value and credibility, the Fed also decided to dilute the collateral requirements for accessing the TAF. It quickly announced a schedule for auctioning off $40 bn in two instalments, and proceeded to do the same.

The plan may or may not succeed. In fact, it is most likely to have very limited impact on the huge credit problems, given that the total amount proposed for auctions, not more than $100 bn, is a small drop in the ocean. More fundamentally, it does nothing to solve the more fundamental solvency problems facing many banks, saddled with dubious quality ABS. Central Bank interventions and credit infusions may be able to contain a liquidity crisis, but not a solvency crisis. The deep seated problems will take more than window dressing or credit infusions, it may need a full fledged recession to wring out all the excesses and bad debts. With the sub-prime bubble not fully deflated, the banks will have to immediately absorb and then get over the ever increasing losses in both their direct balance sheets and that of their off-balance sheet SIVs. The moral hazard concerns inherent in such actions is all too obvious to be repeated.

Apart from the merits of these measures, what is significant is the resolve and the success of these autonomous institutions in coming together and agreeing to a unified action plan. It is an acknowledgement of the futility of individual economies or Central Banks acting alone against the massive economic forces unleashed by financial liberalization and globalization. It is also a testament of the fact that global financial markets are much more integrated than the real economy, and hence its problems demand concerted action.

It is also an indictment of international bureaucracies like the IMF or WTO, which regularly fail to achieve agreement among its members and respond effectively to global challenges. After all, there have been numerous examples of the IMF failing miserably in agreeing to respond effectively to both pre-empting and managing macroeconomic instability in many parts of the world. Unlike these international agencies, which face hostility from nation states in pooling their sovereignty, the Central Banks are direct representatives of their nations. The fact that they are professional and independent bodies, confers on them certain advantages and flexibility in acting when circumstances demand collective action. That they are, by and large, insulated from political compulsions, is a critical factor in their freedom of action.

Has the time come for setting up Climate Change Boards, with professional experts and endowed with some level of independence, that represents nation states at meetings like the recently concluded International Climate Change Conference? Do we need to have professional Anti-terrorism Agencies, which pools the expertise and intelligence resources of nation states, to address global security challenges like terrorism? Do we have the rudiments of a model for taking collective decisions on global challenges?

Monday, December 24, 2007

As the China and India led developing world (5/6th of humanity) joins the energy intensive development bandwagon, the newly released World Energy Outlook has many insightful observations. Martin Wolf lists out a few of them in his FT column.

1. If governments stick with current policies (which the IEA calls the “reference scenario”), the world’s energy needs will be more than 50 per cent higher in 2030 than today, with developing countries accounting for 74 per cent, and China and India alone for 45 per cent, of the growth in demand.

2. This huge increase in overall demand occurs even though energy intensity of gross world product falls at a rate of 1.8 per cent a year.

3. Fossil fuels are forecast to account for 84 per cent of the increase in global energy consumption between 2005 and 2030.

4. World oil resources are, insists the IEA, sufficient to meet demand at prices close to $60 a barrel (in 2006 dollars). But the share of world supply coming from members of the Organisation of the Petroleum Exporting Countries will rise from 42 per cent to 52 per cent. Moreover, “a supply-side crunch in the period to 2015, involving an abrupt escalation in oil prices cannot be ruled out”.

5. Coal’s share in global commercial energy is forecast to rise from 25 per cent to 28 per cent between 2005 and 2030, because of its role in power generation. China and India already account for 45 per cent of world coal use and drive over four-fifths of the increase under the “reference scenario”.

6. Some $22,000bn (a little under half of 2006 world gross product) will need to be invested in supply infrastructure, to meet demand over the next quarter century.

7. Even with radical measures to reduce the energy intensity of growth under the “alternative policy scenario”, global primary energy demand would grow at 1.3 per cent a year, only 0.5 percentage points a year less than in the “reference scenario”.

8. China will become the world’s largest energy consumer, ahead of the US, shortly after 2010.

9. Under the reference scenario, emissions of carbon dioxide will jump by 57 per cent between 2005 and 2030. The US, China, Russia and India alone contribute two-thirds of this increase. China becomes the world’s biggest emitter this year and India the third largest by 2015.

10. Even under the IEA’s more radical “alternative policy scenario” CO2 emissions stabilise only by 2025 and remain almost 30 per cent above 2005 levels.

More than any other challenge, energy related problems pose the biggest risks for human survival. The global warming and related climate change problem is directly dependent on our energy consumption, and it is difficult to see how it can be controlled without significantly cutting down on energy production. This is made difficult by the direct link between economic growth and energy consumption.

Martin Wolf argues that the world which moved from a zero-sum imperialist economy to a positive sum one (in which every one benefits politically and economically, and in which people and countries trade to improve their lot), is now again threatening to slip back to a zero-sum one. He writes, "The biggest point about debates on climate change and energy supply is that they bring back the question of limits. If, for example, the entire planet emitted CO2 at the rate the US does today, global emissions would be almost five times greater. The same, roughly speaking, is true of energy use per head. This is why climate change and energy security are such geopolitically significant issues. For if there are limits to emissions, there may also be limits to growth. But if there are indeed limits to growth, the political underpinnings of our world fall apart. Intense distributional conflicts must then re-emerge – indeed, they are already emerging – within and among countries."

UpdateGeography Professor Jared Diamond has a delightful article in the NYT, where he makes a strong case for a convergence in living standards, as the only solution to the massive consumption challenge facing the planet.

Sunday, December 23, 2007

The Government of Andhra Pradesh is considering extending its flagship Pavala Vaddi loan scheme to helping students pursuing higher education. Under the Pavala Vaddi scheme, the state government have been providing subsidized interest loans (3%) to Self Help Groups (SHGs) who maintain discipline in their repayment obligations. More than the SHGs, higher education for poor students is an excellent example of a poverty eradication, as opposed to poverty alleviation, policy intervention. Higher education is one of the surest, economically efficient and least distortionary ways of ensuring that a poor family is lifted into a higher growth trajectory.

But instead of using Government intervention to catalyse and broaden a market in such lending, such schemes often end up trying to ambitiously cover all the beneficiaries directly by the Government. This is unsustainable and is a recipe for incentive distortions creeping in and the inevitable failure of the program. Any Government assistance should be leveraged to cover as many students as possible, while at the same time developing the market itself. Like for the farmers, the major problem for students looking for financing is not high interest rates, but the lack of access to credit. So more than focussing on the interest rate component, Government efforts should be towards creating this market.

For example, with the handsome interest subsidy, the student loan becomes similar to any high risk loan given by the bank. Therefore the arrangement reduces the banks to passive spectators in the whole lending process. The more enterprising banks should be jumping at this opportunity, which is a huge windfall, with little effort. The Government can get better results by incentivizing banks and fostering competition among them.

One way of doing this is to use the interest subsidy to provide a credit enhancement facility, that competing banks could draw on. In fact, there could be an auction or an open tender for finalising a select panel of banks eligible for accessing this credit enhancement facility. This would incentivize banks, open up competition, draw in private banks, broaden the market, and lower financing rates. It would also be a more efficient way of allocating scarce subsidy resources. Apart from this, for the initial period, the Government could continue direct subsidy for a few categories. While this is only one model, there are a number of other models available, all of which seek to leverage the interest subsidy to create a market.

An increasing number of commentators and economists, led by Nouriel Roubini, have been saying that the sub-prime mortgage crisis is more a solvency problem than a liquidity crisis. This is borne out by the fact despite the hundred of billions of dollars and euros liquidity injections and a 100 basis points cut by the Fed in the US, over the last three months when the bubble strated signs of having the potential of dragging the economy with it, the bad news continues to tumble in. Simple monetary and other supply side interventions will not solve the more fundamental credit quality related problems. But neither does it dispense with the need for monetary easing.

Nouriel Roubini tracks the extent of damage inflicted till now, "Indeed, you have two million plus US households that will likely default on their mortgages; dozens of mortgage lenders who have already gone bankrupt; plenty of homebuilders suffering losses and closing shop; highly leveraged financial institutions all over the world (US, UK, France, Germany, Australia, etc.) that made reckless investment and have gone belly up; and even corporate firms defaults will now start to sharply increase as the economy falls into a recession. Also, the size of the financial losses are staggering and growing by the day: financial institutions have so far recognized about $50 billion of losses but a variety of analysts estimate that total losses in sub-prime alone could add up to $300 to $400 billion; add to those the losses in near prime and prime mortgages; the losses on credit cards and auto loans whose default rates are rising; the losses on commercial real estate that experienced a boom and bubble similar to residential real estate; the losses that will be suffered by banks on lending to corporate firms and in LBO deals. It will all add up to a staggering figure closer to $1,000 billion of losses."

Roubini calls it the first crisis of financial globalization and securitizations, "Given such losses, the necessary contraction of credit by financial institutions that have lower capital could reduce the stock of credit – and thus cause a massive credit crunch – of the order of several trillions US dollars. In turn, such credit crunch will make the quantity of credit lower and its cost higher for households, firms and borrowers in general, thus reducing aggregate demand. Moreover, given securitization and financial globalization these losses are spread not just among banks but also investment banks, hedge funds, mutual funds, money market funds, SIV and conduits, insurance companies in the US and across the world. Thus the financial contagion is spreading from banks to the rest of the financial system and from the US, Europe and the rest of the world increasing the risk of a systemic financial crisis."

"Thus, no wonder that major financial markets are now in a seizure of credit and liquidity: interbank markets, SIVs financed by ABCP, securitization markets, derivatives markets, LBO markets, leveraged loans and CLO markets. Given uncertainty on the size of the losses and on who is holding the toxic waste assets everyone is afraid of their counterparty and is hoarding liquidity. This is the effect of having created a financial system with less transparency, more opacity and lack of information and financial disclosure."

Roubini also says that the individual consumer will not be spared, "The saving-less and debt burdened US consumer is now at a tipping point. It cannot use any more its home as an ATM machine by borrowing against it and spending more than its income as home wealth is now falling. This consumer is buffeted by many negative shocks: falling home values, falling home equity withdrawal, rising debt servicing ratios, a credit crunch in housing and consumer credit, rising oil and gasoline prices, a weakened labor markets and, soon enough, a falling stock market."

Any liquidity crisis at this time of the year will have more long term effect and on the real economy. Private consumption spending forms 70% of the US GDP. The coming Christmas and New Year period are the peak sales periods, (forming upto half the annual sales of many products) and the rapidly disappearing "income effect" (coupled with a fast increasing "debt effect"!) is likely to seriously dent consumption spending. The free spending US consumer had been using the booming home prices and the tech stocks before, like an ATM to borrow against. At a time, when private sector investment spending in Europe and especially US is stagnant and even falling, a poor year-end sales season will surely postpone future investment decisions. The inflationary expectations fuelled by rising oil and commodity prices and weakening dollar, will only strengthen recessionary trends.

And the consequence of all this on the vital credit markets that drive the global economic growth, especially with private sector investment spending stagnating since 2004 and a recession looming, could be catastrophic. In fact it could be the decisive factor in determining the extent of any future recession.

Roubini accepts that recession is inevitable in the US and Europe, even with any monetary easing. But despite the limitations of monetary policy, Roubini argues that in its absence the inevitable recession is likely to be steep and long, and have far reaching consequences. He feels that while monetary easing will not prevent a US recession that is now necessary to clean up the credit mess, leverage and excesses that were built up in the last six years such monetary easing may reduce the length of such a recession and dampen its depth. He argues, "When bubbles go bust the Fed can only minimize the collateral damage to the economy and reduce modestly the severity of the losses; it cannot prevent massive losses and sharp falls in asset prices from occurring as the experience with the S&L boom and bust in the late 1980s and the tech boom and bust in the late 1990s suggests."

Calling for bigger and more definitive cuts in interest rates, he argues, "When your home is on fire and there is serious risk of fire contagion to all of your town and beyond you want the entire fire brigade to provide enough liquidity to avoid entire edifice and town burning to the ground. And using hand-held and hand-carried buckets of water while pondering the intellectual merits of moral hazard of fire insurance in order deal with a major five-alarm fire - rather than using immediately your global fire brigade - is delusional. So it is time for the international central banks’ liquidity fire brigades to turn on the hoses and dealing with this most dangerous global fire."

He writes, "So the time for band aid measures and clever but ineffective palliatives is over: only a monetary policy ease could make some difference in reducing the level of interbank rates (if not the interbank spreads) and avoid the sharp tightening in monetary conditions and rise in real short term interest rates that the spike in interbank spreads has created."

About the need to bail out the real economy and prevent milliions of job losses, he writes, "And it does not make sense to avoid bailing out the real economy – and preventing a massive global loss of incomes and jobs – just in order to punish reckless lenders and investors in the financial market and thus avoid moral hazard. Moral hazard in financial markets is contained via sensible credit policy and appropriate regulation and supervision of financial markets. In times of economic danger bailing out the real economy with monetary easing may have the by-product of partially reducing the financial losses of reckless lenders and investors (an indirect bailout). But the first order costs of a global recession is much larger than the second order costs of partial moral hazard; such moral hazard will be kept in check by hundreds of billions of dollars of losses that will occur regardless of monetary policy easing and via sounder regulation and supervision of financial markets in the future up-cycle of credit."

He also feels that the fears of inflation are misplaced and on the contrary, predicts global disinflation in the aftermath of the recession, for the following reasons. a) a fall in US aggregate demand relative to supply;b) a slack in labor market conditions and slowdown in wage growth as the unemployment rates sharply increases;c) a fall in global aggregate demand as the glut of output from overinvestment in China and some other EMs will face a fall in global demand as the world recouples with the US hard landing;d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges. We are set for the repeat of the 2000-2003 cycle when the Fed and other central banks underestimated the downside risks to growth and overestimated the upward risks to inflation and ended up having to aggressively cut rates to deal with the fall in economic activity and the deflation risks that such a US and global recession triggered.

Roubini also lists out the likely objections to any monetary easing now, and argues against the primary objections. The major concerns are primarily the followinga) such monetary easing will not prevent a hard landing and will only postpone the necessary restructuring after a reckless credit-boom driven asset bubble;b) it will cause moral hazard and possibly create future bubbles;c) it may lead to higher inflation.

It is true that these remain the major immediate concerns of a monetary easing. But the case made out against each is less than convincing. The comparison with the tech bubble bust is wholly inappropriate given that unlike the mortgage crisis, the tech bubble affected only a small portion of both the real economy and the financial markets. The reasons given against inflation are assumptions, all o which are in turn based on further assumptions which stand on shaky foundations. Roubini and most serious commentators agree that a hard landing is inevitable and even desirable. Given this scenario, and also given the potential for huge losses, any monetary easing will introduce severe distortions in the market. The Government is itself likely to be sucked into misguided bailout efforts dressed up as efforts to prevent the contagion from spreading to the real economy. This is time enough for the development of a few more toxic financial products and their being offloaded into unsuspecting investors. One does not need to look far into history to know that such delaying the inevitable has only helped generate numerous other unpredictable distortions.

Here is a classic case of an economy which suffers from serious macroeconomic imbalances The low inflation, low interest rate, credit and asset booms of the last two decades has spawned in its wake massive current account deficits and a negative household savings. These imbalances had been building up for a very long time. But for small blips, this has been one long unsustainable boom. The single critical parameter driving the imbalances has been credit, and any effort to pump in more of the same will, in all probability, only distort the market. Monetary easing to address any recession now, is a little like fighting fire by pouring more fuel!

Update Greg Mankiw has his views on what to do during teh coming recession, in his NYT column, How to Avoid Recession? Let the Fed Work. He feels no need for any Government intervention and feels that the Fed should be given the freedom to act as the situation warrants.

Saturday, December 22, 2007

In the past few days, the Securities and Excahnges Board of India (SEBI) has announced a slew of measures aimed at liberalizing the equity markets, thereby improving its breadth and depth and increasing market liquidity. The latest measure permits short selling by all categories of investors, which had been completely banned since the Ketan Parekh scam in 2001. Short selling is the practice of selling stocks which the seller does not own at the time of the sale. He borrows the stock(s) from another party, with an undertaking to deliver it back within a pre-determined time. He then sells it in anticipation of falling prices, so that it can be bought from the open market when the prices fall and delivered back. The short seller would thus make a handsome profit in this transaction.

This follows other measures like reducing the minimum lot size for derivative contracts, so as to encourage more retail investors to enter the derivatives market and hedge their positions. It has eased the stringent listing requrements, so as to make it easier for a select group of companies to raise money. It has also permitted stock exchanges to offer derivative contracts for foreign exchange, which enables buyers settle derivatives contract in foreign currencies.

While all these measures are inevitable and are clearly aimed at improving the efficiency of the financial markets, questions have to be asked about the timing and phasing of these measures. Consider the scenario. The Indian equity markets are in the middle of a massive bull run, which has seen it breach the 20000 mark recently. In 2007, it has risen by over 45% in rupee terms and over 60% in dollar terms. Questions are being asked about the valuations of Indian stocks, with sceptics pointing to the higher than normal PE and PB values. (Sensex PB value is 6.6 and PE multiple 27, while the BSE 500 ratios are 6.4 and 27.5) Further, the year end is time of the year for profit booking and market stabilization.

The past few months have seen unprecedented activity by Foreign Institutional Investors (FIIs) in the emerging markets. India has been at the forefront of this trend in attracting FIIs. While Indian markets attracted $27 bn in 2006, FII investment has crossed $45 bn till December 2007. With a weak dollar, low bond yields, high US current account deficit, inflationary expectations, and a looming recession in the US, emerging markets investments continue to look excellent. Unlike China and the rest of Asia, Indian economic growth appears relatively decoupled from the US and Europe. In the circumstances, India will, in all probability, continue to attract FII investment for the foreseeable future.

Introducing measures that would only fuel the bull run at this point of time may look a little inconsistent with the standard prescriptions. But the other dimension to the arguement is that the markets appear to be nearing the end of the bull run, and any shorting opportunity will only give the market players an ideal opportunity to hedge themselves against any downside.

The extremely volatile nature of the financial markets makes them vulnerable to even small shocks. Under the circumstances, timing and sequencing becomes a critical factor in the introduction of any new regulations or policies. The present round of liberalization has to be seen in that context.

Could SEBI have waited for the bull run to end or for atleast a small market correction, before introducing these measures? Will these measures engender an "irrational exuberance" in Indian equities? Or is there enough room to sustain the bull run, given the relative insulation of Indian economy from the US financial crisis? Could the SEBI not have waited for the emerging market craze to die down before opening up further to foreign currency investments? Only time will tell whether SEBI was right in pushing through these reforms now or not!

Friday, December 21, 2007

A Government of India Committee in Public Transport has recommended the setting up of a regualtory transport body, with the power to enforce physical restrictions on the use of personal vehicles and limit the availability of road space for them. Its other suggestions are - a cap on the number of cars per household by restricting ownership of vehicles; stonger penalties like suspending and cancelling licences in case of traffic violations and accidents; specifying minimum basic service standards for transport industry; identifying busy areas; and including popular shopping destinations in every city, as "traffic free zones". It has also recommended levying a congestion charge on personal vehicles.

Some of the recommendations are long overdue and should be implemented, while others like cap on ownership of vehicles are bound to distort incentives and fail. Implementing some of them will throw up interesting challenges. The most interesting possibility arises from the recommendation on a congestion tax.

Congestion charge became popular with London Mayor Ken Livingston's decision to introduce it on road usage in certain areas of London in 2003. The policy yielded immediate results with significant reduction in congestion, especially in the city center and is now widely acknowledged as a success. The London scheme requires drivers to pay £8 per day if they wish to continue driving in central London during the scheme‘s hours of operation or 7.00 AM to 6.00 PM on working days. The vehicles have to be registered and cameras read the vehicle registration mark as you enter, drive within or exit the Congestion Charging Zone and check it against the database of registered vehicles.

The Adam Smith Institute has this to say about road pricing. "Road pricing has the potential to ease traffic congestion in cities and elswehere. Imposing a price deters marginal users, who respond by not travelling (making the children walk to school instead of driving them, for example, or shopping more locally rather than in town), or car-sharing, or planning their tasks so that they need to make fewer journeys, or by using public transport, or by travelling at some less congested time. A charge that is limited to the morning and afternoon peaks may be sufficient to have a clear effect on congestion, as people decide to make their journey a little earlier or a little later in order to avoid the charge.

One problem, however, is how and where to draw the boundary. A cordon system, whereby all journeys into the city boundary are charged, may raise revenue, but will not necessarily reduce congestion on particularly problematic junctions and streets. If only the most congested areas are priced, residents just outside the border may complain that they face large charges for short journeys (such as to the local shopping centre or school) that take them over the line. And the fear is that people will park in residential streets in order to avoid driving into the centre and facing the charge. Many of these, and other problems, can be solved by an electronic system, which allows pricing to be made highly discriminatory. In principle, there does not need to be any boundary ring - individual streets and junctions can be charged. The data collected through electronic systems can also be used to help plan future road infrastructure."

Daniel Gross in the Economic View column of NYT, What’s the Toll? It Depends on the Time of Day, outlines the advantages of congestion pricing. "Congestion pricing — the concept of charging higher fees to consumers for a good or a service at times of heavy use — is well established in businesses like hotels, long-distance phone service and air travel."

The latest edition of The Economist carries an article about a proposal for road pricing in the UK. It argues, "A pricing system would solve the biggest problem faced by motorists: the lack of a proper way to allocate capacity. The current tax system penalises more polluting cars, and those that consume more fuel. But congestion costs go unpaid. In the absence of charging for road space, capacity is rationed instead by delays and queues. And whereas congestion is concentrated in urban areas and along big trunk roads, the burden of road tax is spread equally (and unfairly) across both rural and urban drivers."

The RAC Foundation in the UK have come up with a report in favor of road pricing. Its studies show that, "Having a meter in the car outlining the cost of each journey will lead to a reduction in journeys by highlighting the actual cost of the trip - RAC Foundation research has found that most motorists regard fuel, tax and insurance as "sunk costs" and do not relate them to individual journeys. In Oregon the "pay as you go" group showed a reduction in miles traveled even thought they were paying the same amount as those paying tax at the pumps. Where the charge varied at rush hour there was a 20% reduction in travel."

Governments being sensitive to public opinion are naturally apprehensive of any new taxation proposals. Here the success of Ken Livingston selling the congestion tax by sugar coating it with a commitment to improve public transport is instructive. The RAC report advocates an eminently sellable scheme whereby fuel duty (at around 50p a litre, among the highest in Europe) is abolished and replaced with a 14p carbon charge. Motorists would then pay per kilometre according to how busy the road was. City drivers (currently subsidised by their rural counterparts) would pay more, while country drivers—or those who avoid the rush hour—would pay less.

Congestion tax will take some time to come to India, especially given the need for it to be non invasive. This will require installation of electronic devices, sensors and cameras along roads, and maintaining databases of vehicles registration and other information. Vehicle owners too will have to share the expenditure involved in monitoring this. But it is only a matter of time before some form of restrictions make their entry into our cities too.

Update 1 (3/6/2011)

In 2008, New York Mayor Mike Bloomberg's proposal to charge drivers $8 to enter a congestion zone in Manhattan south of 60th Street during peak hours was defeated in the Council. Critics viewed the proposed congestion fee as a regressive measure that overwhelmingly benefited affluent Manhattanites.

The Wall Street firms are being effectively bailed out by the Sovereign Wealth Funds (SWFs) of China and other Asian financial superpowers. The list of Wall Street high and mighty reeling under the devastation wreaked by the sub-prime mortgage crisis is a veritable list of who is who of the investment banking world - UBS ($13.5 bn), Citigroup ($11 bn), Merrill Lynch ($8 bn), Morgan Stanley ($9.4 bn), HSBC ($3.4 bn), Bear Stearns ($5 bn), Deutsche Bank ($3.2 bn), Bank of America ($3 bn), Barclays ($2.6 bn) etc And this list is increasing every day and the losses mounting even faster. It is expected that in the coming few months, many hundred off billions of SWFs would have flown into the attractive investment opportunities presented by these Financial Institutions.

Consider the story till date. The Abu Dhabi Investment Authority has donned the white knight's role and invested $7.5 bn in the Citigroup, for a 5% stake, giving the embattled Citi breathing time. Government of Singapore's Temasek Holdings have poured in $9.7 bn to UBS after it reported write downs of over $13.5 bn over its sub-prime mortgage holdings. Oman Government Fund has added a further $1.7 bn to UBS. In October, Bear Stearns agreed to a $1bn investment from Citic Securities, which is controlled by China's government. The Chinese Development Bank, controlled by the Chinese state, owns 3% of Barclays. Morgan Stanley received a $5 bn infusion, or a 9.9% stake from the China Investment Corporation (CIC). The list of white knights on the lookout for similar investment options is large, given the over $2.5 trillion available with SWFs.

Call them white knights or financial raiders, but for their timely infusions the story could have been worse still. These legendary institutions could have fallen into terminal crisis, thereby severely denting confidence and dragging down the entire financial market. To that extent, it may not be incorrect to claim that Asian and Oil producing nations' taxpayers have been subsidising the bail out of US and European Financial Institutions (FIs). But these investments are also excellent opportunities for the SWFs to take stakes in some of the biggest FIs, at a cheap cost and relatively favorable terms. For example, the CIC stake in Morgan Stanley is structured so that it is guaranteed a 9% annual return till it converts its investment into equity in 2010.

For now, there is little opposition in the US to these infusions. The US law makers and Wall Street opinion makers realize the dire need for such inflows at this time and feel that it may be detrimental to their interests to scare away these good samaritans. Many of these investments are also adequately regulated in so far as it limits the investors to be passive investors, with no seat on the Board. This is in stark contrast to the outcry generated in the aftermath of the $18 bn bid for Unocal by Chinese state-owned oil firm CNOOC in 2005 and the Dubai Ports World's takeover of some strategiucally important US ports in 2006.

The situation is ironical in that it is an exact inversion of the East Asian economic crisis of 1997, when the large Wall Street Firms had a grand ball, knocking away stakes in many local FIS at very cheap rates! The wheel has now come the full circle!

Update 1:On December 24th, Singapore's Temasek Holdings announced the investment of $6.2 bn in Merrill Lynch.

Thursday, December 20, 2007

In a belated acknowledgement of the reality, Alan Greenspan has given his considered opinion on various monetary policy related issues in a WSJ article, The Roots of the Mortgage Crisis. After more than a quarter century of being at the helm of the Federal Reserve, he appears to have come to the following conclusions, all of which have important ramifications on policy making.

1. Monetary policy or other policy instruments are ineffective in deflating asset bubbles. 2. Long term interest rates have been decoupled from national or local economic forces (and to that extent Central banks) and are dependent on global economic trends. Asset prices are getting decoupled from short term interest rates. 3. Role of Central Banks will be increasingly limited to influencing short term interest rates

He is categorical in asserting that bubbles cannot be safely defused by monetary policy. He writes, "After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century."

In a belated but unambiguous acknowledgement of his role in ushering in long term distortions to the US economy, he writes, "I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major."

It is very difficult to judge the success or otherwise of monetary policy interventions. He says, "I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one."

He highlights the peculiar phenomenon of long term interest rates remaining stable and constant despite the 17 continuous quarters of monetary tightening by the Federal Reserve, as the definitive proof of the inefficacy of monetary policy, in deflating bubbles.

He writes, "In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates. Arbitragable assets--equities, bonds and real estate, and the financial assets engendered by their intermediation--now swamp the resources of central banks. The market value of global long-term securities is approaching $100 trillion. Carry trade and foreign exchange markets have become huge."

Wednesday, December 19, 2007

Update"Kilo Funding" explainedKilos are CDOs raised initially by top Bear Stearns fund manager Ralph R Cioffi, to fund two hedge funds operated by Bear Stearns. Unlike other CDOs, Kilos sold commercial paper and other short term debt (tapped into the $2 trillion money market accounts in which indivduals and corporations stash their spare cash) to buy higher yielding, longer term asset backed securities. The Kilos helped raise cash for the hedge funds, which were owned by the owners of the Kilos. The money was also used to purchase billions of mortgage backed securities owned by the Kilo itself (through its hedge funds), thereby driving up the returns for these funds. The Kilos also allowed the hedge funds owned by the Kilo issuers the freedom to lock in long term financing. (Typically hdge funds borrow for short periods - days and weeks)

The Kilos offered higher than normal money market yields and repayment was also guaranteed by Wall Street Banks (through what is known as a "liquidity put"). The Wall Street Banks benefitted from the substantial fees paid for the liquidity put, and the purchases of their mortgage backed securities and other debt by the hedge funds owned by the Kilos.

In many ways, Kilos were the fore-runners for the Special Investment Vehicles (SIVs). For a long time, the Cioffi run Kilos were the sole funding source for the Cioffi run hedge funds of Bear Stearns.

It is taught in Eco 101 classes that taxes drive a wedge between the suppliers and producers and thereby prevents the most efficient allocation of resources, reduces the total surplus and causes a deadweight loss. By this calculation, a tax on labor will both reduce the amount of labor supplied and the amount of labor demanded, as the wages falls and the cost of labor rises. Consequently, unemployment rises and the economic growth gets affected.

But reality would seem to indicate a more complex set of outcomes. It has been found historically that high marginal income tax rates have subsisted with low unemployment and high economic growth. This variation in outcomes can be traced back to the varying response by different categories of labor to taxation. It is self evident that the relatively poorer people have limited options even if the wages fall, while the more well off have more options. Irrespective of the wages, the poor have to work as many hours as they always do, because they only earn just about enough to make ends meet. In other words, the lower and lower middle class are therefore price takers, or they exhibit inelasticity in supply when faced with changing wages.

In contrast, the more well off have more options when faced with a fall in wages, due to taxation. They can do less overtime, the second earning member can even leave the job, the elderly can retire earlier, or they can give up their second job. In other words, the labor supply is elastic among the well off classes, when faced with falling wages. But when it comes to the very richest, their incomes are so high, that the dent made by the tax on their incomes is so small and the marginal benefit accrued by every additional unit of work done is so high despite the taxes, that they exhibit inelasticity in labor supply when faced with fall in wages.

From the aforementioned analysis, we can draw a few conclusions1. The distortionary effects of labor taxation are less likely to be manifested among the poorer classes. The deadweight losses increases as the income levels go up, but starts falling with the very richest. An inverted U curve relationship seems to exist between income groups and deadweight loss of taxation. 2. The developing countries, with greater proportion of lower income people and wage labor, will experience less distortions with labor taxes. In contrast, the developed countries, with more well off citizens, are likely to experience economic distortions due to high taxes on labor. 3. Among different occupations too, those highly specialized jobs with limited market (both supply and demand) will experience less deadweight loss due to any labor tax. However, in case of the more commonplace jobs, which have greater flexibility in both supply and demand, labor taxes cause significant deadweight losses. 4. Flexible labor markets are likely to suffer higher deadweight losses and hence experience more distortions than the more rigid labor markets. This is another reason why labor taxes are likely to cause greater econommic distortions in developed countries than developing countries.

However, in the real world, due to the interaction of certain other factors (whose identity and extent of influence is uncertain and difficult to predict) and the presence of certain specific circumstances, the outcomes could be different.

1. The socio-economic background of students significantly affects test performance - the lower the income of a child's family, the worse he is likely to do on the exam.

2. The socio-economic and cultural standards of fellow students play an even more crucial role in determining the performance of a student. The report says, "Regardless of their own socio-economic background, students attending schools in which the average socio-economic background is high tend to perform better than when they are enrolled in a school with below socio-economic intake. In the majority of OECD countries, the effect of the average economic, social and cultural status of students in a school... far outweighs the effects of the individual student's socio-economic background."

Therefore it is not surprising that since a large portion of US black and Hispanic students are isolated in high-poverty schools that universally face enormous educational obstacles, their average test scores are far below the levels for whites. In contrast, African-American and Hispanic students attending middle-class schools do much better on standardised tests.

The report observes, "Among fourth-graders in 2005, 48% of blacks and 49% of Hispanics attended schools in which more than 75% of the students were eligible for free or reduced-price lunch. By comparison, only 5% of white students attended such high-poverty schools. Nearly three-quarters of all black and Hispanic students go to schools with at least half the enrolment eligible for subsidised lunch."

3. Private schools do not necessarily perform better. The report says, "On average across the OECD, students in private schools outperformed students in public schools in 21 countries, while public schools outperformed private ones in four countries. The picture changed, however, when the socio-economic background of students and schools was taken into account. Public schools then had an advantage of 12 score points over private schools, on average across OECD countries. That said, private schools may still pose an attractive alternative for parents looking to maximise the benefits for their children, including those benefits that are conferred to students through the socio-economic level of schools’ intake."

4. In favor of competition between schools, the report observes, "Across OECD countries, 60% of students were enrolled in schools whose principals reported competing with two or more other schools in the local area. Across countries, having a larger number of schools that compete for students is associated with better results, over and above the relationship with student background."

5. About teachers and other resources, the report says, "Resources such as an adequate supply of teachers and quality of educational resources at school are on average across countries associated with positive student outcomes. But many of these effects are not significant after taking account of the fact that students from a more advantaged socio-economic background tend to get access to more educational resources."

Sunday, December 16, 2007

Some 285 million Indians, or 29% of its population, live in its over 5161 towns and cities. In the Eleventh Plan period (2007-12), 36.8 million people are expected to be added to the urban areas. Rapid urbanization and managing its consequences is one of the most important challenges facing Governments across the world, especially in the developing world. This process has triggered off a lively debate about its impact on increasing incomes and reducing poverty.

There are interesting views on the issue of rural-urban poverty. Quoting the latest CSO figures, a group of economists of the Future Group, have come up with a report "Is Urban Growth Good For Rural India?", which claims to debunk some closely held notions of the urban-rural divide in the Indian economy. It argues against three such myths

1. Faster economic growth in urban areas is driving the urbanization. But India’s rural economy has grown on average by 7.3% year-over-year over the past decade, against 5.4% in the urban sector and per capita rural income growth has been more than double that of urban India. The rural economy accounted for 51% of India’s national domestic product in 2005-06, up from 49% in 2000 and 46% in 1993-94.2. Rural India is still an agricultural economy. Agriculture formed just over half of the rural economy in 2000, down from 64% in the early 1980s and 72% in 1971. Services accounted for 28% of rural economy in 2000, up from 21% in 1981, while manufacturing, utilities and construction have nearly doubled their share in the rural economy to 18% in 2000 from just under 10% in 1971. The growth has been led, in large part, by three industries: manufacturing; construction; and trade, hotels and restaurants. 3. Rural-urban inequality is on the rise. India’s urban-rural income gap, the ratio of mean urban to rural incomes, diminished to 2.8 in 2000 from 3.3 in the early 1990s. Real rural household consumption expenditure grew by 8% against 4% in urban India in the 2000-05 period.

They argue that the Government have hitherto focussed on rural inequality and rural investments, to the exclusion of the urban areas. Concluding that it is wrong to see urban and rural growth as separate activities, they say, "Our study suggests that a Rs100 increase in urban consumption could lead to an increase in rural household incomes of up to Rs39—no small feedback, and a strong counter to the popular perception of “two Indias”. If India’s cities keep growing at their current pace, in aggregate 6.3 million non-farm jobs in rural areas (more than the total number of new professional services jobs projected over the next 10 years) and $91 billion in real rural household income could be created over the next decade. Urban consumption also generates non-farm employment. A 10% increase in urban expenditure is associated with a 4.8% increase in rural non-farm employment."

In another interesting study, marshalling an impressive array of newly compiled statistics, Martin Ravallion of the IMF writing in the Fund's quarterly magazine, Finance & Development, argues that urbanization may be contributing towards global poverty reduction. He draws the following conclusions on global poverty1. The incidence of absolute poverty is appreciably higher in rural areas. Poverty in rural areas is markedly higher than in urban areas, despite the urban poor facing much higher cost of living. While 69.7% of the rural poor lived on less than $2 a day in 2002, compared to only 33.7% of urban poor.2. Urban areas share of the total global poor is rising slowly. It rose from 23.6% to 26.2% in the 1993-2002 period. ($2 a day poverty line)3. The poor are urbanizing faster than the population as a whole, reflecting a lower pace of poverty reduction in urban areas. 4. Urbanization is a generally positive factor in overall poverty reduction. More urbanized developing countries tend to have lower poverty rates.

What is the impact of rapid urbanization through migration from rural areas, on the lives of rural poor and rural poverty in particular? Martin Ravallion argues that the rural poor migrating to urban areas contribute towards reducing rural poverty by sending remittances back home and by reducing the demand and hence competition for rural jobs. Indeed he shows evidence to prove that urbanization has done more to reduce rural than urban poverty. This is interesting in that conventional wisdom would expect that human resource depletion from rural areas, especially those more skilled and educated, would have impoverished the rural areas. But here it appears that the negative effect of human resource depletion is more than offset by the aforementioned positive effects of migration.

He says, "Rural poverty measures tend to fall more rapidly in countries with higher rates of population urbanization. Urbanization appears to be having a compositional effect on the urban population, in that the new urban residents tend to be poorer than the previous urban population. Naturally, this slows the pace of urban poverty reduction, even though poverty is falling in rural areas and for the population as a whole."

What are the implications for Government policies on reduction of urban poverty? If the evidence of both studies is taken as conclusive, we have interesting learnings. If Ravallion's findings are taken as representative of Indian cities too, then it may not be incorrect to claim that faster economic growth in cities is indeed driving urbanization. The higher economic growth of the rural areas, as compared to the cities, may be more of a statistical sleight of hand than any profound conclusion. As the Ravallion study shows, the compositional effect arising from the migration of the poor into rural areas and the consequent decrease of the poor from the rural areas, coupled with the significant transfer of wealth from the urban to rural areas by way of remittances, work towards boosting rural growth statistics while simultaneously under playing urban growth.

Urbanization has an undoubted positive impact on poverty reduction. Not only does it improve the conditions of the migrating poor (at a macro level, the migrants migrate because they are able to access better opportunities in the cities), but it also contributes to the growth of the rural economy. Urban share of the total poor may continue to increase in the coming days, as the poorest from the rural areas find it increasingly attractive to migrate to the cities.

The Fortune Group study also highlights the increasingly prominent role of manufacturing, construction and services in even rural growth. Like urban growth, these sectors too require critical investments in infrastructure like roads, electricity, telecommunications, water, airports and ports for their sustainable long term growth prospects. Hitherto, Government focus in rural economic growth have been confined to or dominated by agriculture related infrastructure investments. While this is undoubtedly important, the increasing importance of other general infrastructure should be kept in mind.

Both studies reveal that migration from rural areas have important positive externalities and economic multiplier, and hence should be incentivized. However, we need to be careful that this migration does not impose costs which overburdens and ultimately derails the urban growth engine. Therefore there has to be a delicate balance between the migration from rural areas and the ability of the City's physical and socio-economic infrastructure to sustain it. Policies tailored to encourage the economic growth of our cities should factor in this dimension. We should not end up killing the proverbial goose that lays the golden eggs!

Saturday, December 15, 2007

The masively growing trade surpluses and fast accummulating forex reserves by Asian Central Banks, and a few recent decisions, especially by the Chinese Government, has thrown up an interesting debate about the possibility of huge amount of these reserves entering the global financial markets. It is estimated that by the end of 2007, the non-industrial countries will hold about $3.5 trillion in foreign exchange reserves and a further $1.5-2.5 trillion in other forms, including sovereign wealth funds.

Effective management of the rising forex reserves is important for a number of reasons. The massive inflows puts an upward pressure on the local currency with respect to the dollar, thereby leading to its appreciation. This in turn affects export competitiveness, and necessitates Central Bank intervention to purchase the dollars, thereby offloading the local currency into the market. This sets up inflationary pressures, and the Central Banks are often forced to sterilize the local currency outflows by issuing Government Bonds, for which it has to incur the interest cost.

The two major concerns for Central Banks in managing their foreign exchange surpluses are liquidity and safety. Faced with not very distant memories of bitter experiences from speculative runs on their currencies, Asian Central banks in particular, have been directing their massive surpluses to US T Bonds. These T Bonds, despite their low yields, offered safety and liquidity in abundant measure. But now, with a weakening dollar and surging reserves, the attractions of T Bonds have started waning. These countries have started looking at more remunerative investment options and more professional management of the reserves. Sovereign Wealth Funds (SWFs) have consequently emerged, attracting strong opinions from many quarters.

The whole SWF story has gained importance especially because of the looming Chinese presence. The Chinese forex surplus has grown 45.1% in the first nine months of 2007 to $1.43 trillion. Its trade surplus was $177.5 bn for 2006, and is expected to be well over $225 bn for 2007, thereby further swelling the forex reserves. At the start of the year, China held $350 bn worth of low-yielding US T Bonds, and $230 bn bonds in US Government backed agencies like the Freddie Mac and Fannie Mae. In June 2007, the global financial markets got a wake up call as the Chinese announced the purchase of a $ 3 bn (non-voting), 10% stake in one of the largest Private Equity firms, Blackstone Group. With its reserves far in excess of the required amount for hedging foreign exchange risks, the Chinese Government set up a new fund, China Investment Corporation (CIC) with a corpus of $200 bn to get higher yields on its surplus.

The story of wealth funds starts with the little known, Petroleum Fund of Norway, worth over $200 bn today. Daniel Gross traces the evolution of this and other similar wealth funds in his article, Avoiding the Oil Curse. The Singapore Government's investment arm, Temasek Holdings, manages assets worth over $300 bn, and is one of the best known examples of SWFs. Since then, the value of such funds have grown manifold, forcing many countries to explore options of making more efficient use of these assets. UBS’s sale of a 9 per cent stake to the Government of Singapore Investment Corporation, and Citigroup’s sale of 4.9 per cent to the Abu Dhabi Investment Authority, are only the most recent examples of the SWF story.

Lawrence Summers explores the recent developments in the emergence of such Funds in Funds that shake capitalist logic. Morgan Stanley has estimated the present value of SWFs to be over $2.5 trillion, and growing at more than $500 bn a year. Prof Summers expresses his view that SWFs would be motivated by concerns other than maximizin risk-adjusted returns, and in the process introduce other variables into the global financial markets. In particular, Prof Summers indirectly hints at the possibility of SWFs becoming instruments of foreign policy and a powerful lever to buy influence.

The influence of SWFs have to be seen in its true perspective. Yes, SWFs are $2.5 trillion today and set to touch $12 trillion by 2015. But this is a miniscule share at 1.3%, compared to the massive, $170 trillion global financial markets today. But the reality of SWFs and the potential challenges posed by them remains and cannot be wished away. The interlocking and interdependent nature of the global financial markets would mean that no country can manage its SWF as an independent arm of its foreign policy, without incurring costs which are most likely to be prohibitively high and hence unaffordable. Such national interest risks can be mitigated by appropriately hedging the investment conditions. In any case such concerns have been part of the financial markets since its origins, especially over monopoly and anti-trust restrictions.

Many of the risks associated with SWFs are also shared with many regular funds. There have been many instances of investments by financial institutions with immediate and even primary concerns which are other than commercial. That strategic considerations are not the exclusive concern of the nations, have been well documented in the actions of the major multi-national companies of the world. These risks are mitigated to a large extent by sectoral restrictions and investment limits. Many countries, including the US continue to place limits on foreign investment in certain strategically important sectors like telecoms, media etc. It is therefore natural that SWFs will be restricted from investments in sectors of national interest like defence.

Martin Wolf, writing in the FT, The brave new world of state capitalism, argues for favoring,"... the emergence of these funds as part of the integration of countries that accept a bigger role of the state in markets than western countries do today. So be it. It is better for such countries to prosper inside the market system than glower outside it. It is absurd to take a country’s exports of oil and refuse to allow it to buy assets, in return."

James Surowiecki, in a recent New Yorker column, Sovereign Wealth World, argues that Governments already own sizeable shares in strategic sectors. He writes,

"In fact, for all the anxiety about government-run funds corrupting the purity of the free market, the truth is that the global economy is already pretty impure. In the U.S., after all, public pension funds account for forty per cent of all institutional investment. In Europe, even now, governments own sizable stakes in a number of major corporations, while in many of the most successful Asian economies government and industry have historically worked hand in hand. Almost eighty per cent of the oil in the world is pumped by state-owned firms, and, even as China’s economy continues to explode, a large percentage remains state-owned. The rise of sovereign funds will create plenty of strange situations, like having a foreign government own your local supermarket—the Qatar Investment Authority recently considered buying the British grocer Sainsbury’s. But it’s not as radical a shift from the current state of things as one might think. Every time you buy gas at a Citgo gas station, after all, you’re doing business with the Venezuelan government, which owns the chain."

There are a few proposals to restrain the power of these funds. One proposal is to limit sovereign wealth fund acquisitions to non-voting shares, in order to avoid political interference in business decisions or strategies. Another possible restriction would put a cap – say 15-20 % - on their share in any company. There are also calls for more transparency - annual or more frequent sovereign wealth fund reports on portfolio composition and investment strategies. But such restrictions are less likely to succeed in the long run.

Ultimately the most definitive hedge against the risks posed by the non-commercial objectives of SWFs is to integrate them ever further into the global financial markets. Interestingly, the ever growing Chinese investments could be the best example of such risk mitigation through deeper integration. As the saying goes, the most effective way of reining in your enemy is to embrace him!

Where does this put India? We have forex reserves of $243 bn and growing. All of its invested in low yielding bonds, and not exposed to the equity markets. Apart from equity and related investments, there are other way of effectively utilizing this surplus. Despite a two year long debate for setting up an Special Investment Vehicle to manage atleast a portion of these reserves, so as to use them to fund infrastructure projects, nothing concrete has come through. It makes great economic sense to utilize this SIV to fund the import of capital equipment and foreign technology, and various consultancy and other services.

Friday, December 14, 2007

Mont Blanc are donating Rs 1000 received from the sale of every Meisterstuck pen in India, to the Red Cross Initiative to reduce illiteracy here. It claims that Rs 1000 will educate one child per year. In an excellent example of reconciling commerical and charitable interests, it exhorts its customers to buy a Meisterstuck pen and "educating as many as possible". The hand crafted Meisterstuck 149, besides being "one of the best known and most famous writing instruments of our time", is also one of the most expensive pens.

The potential inherent in this sales pitch by Mont Blanc may have more universal learnings. Here is a premium brand with a dedicated, niche market following, especially among the very rich. Many of them, for whatever reasons, are likely to approve of being closely associated with some charitable cause and also be known as supporting that casue. The Meisterstuck sales pitch is a superb exapmle of double signalling. First, the company signals to the potential buyers about the charitable dimension, second, the presence of the Meisterstuck pen signals to everyone that its owner is a contributor to a worthy social cause!

Some would argue that the donation component, by raising the price, would put away many customers. But given the donation being a small proprotion of the cost of the pen, and the rich customers less likely to be affected by the small differentials, this apprehension may be misplaced. Further, the marginal utility gained by the customers from contributing to a worthy cause is most likely to be much greater than the increased price. In fact, if anything, tagging a worthy cause is likely to broaden the potential market and thereby attract a few more customers!

I am not concerned with how many pens Mont Blanc will sell and how much money will be raised for the literacy initiative. The more important point for consideration is whether this sales model can be replicated for other luxury brands and philanthropic donations raised. Such sales bundling provides an excellent platform for utilizing the power of the market to raise philanthropic donations. (This concept is not new and has been used by many voluntary organizations like CRY to raise donations through sales of branded greeting cards) Theoretically atleast, it throws up the possibility of raising substantial sums by selling branded premium jewellery, automobiles, and other luxury goods. Here is an ideal opportunity for Tiffanys, Swarovski, Mercedez, Rolex, Luis Vuitton, Armani etc to meet their Corporate Social Responsibility (CSR) obligations and for their rich customers to generously donate to noble causes!

Wednesday, December 12, 2007

With the barest bowling cupboard in a long time, more powerful batting equipments and batsmen, increasing prominence of batting friendly versions like one-day and T20 matches, coupled with dead wickets, it is being claimed that we are witnessing an "age of batting". Some of the batting statistics from the recent past lend ample credence to this arguement.

1. Kumara Sangakkara - In the 17 months since he relinquished the wicketkeeping duties, he has amassed seven centuries in 14 Test innings - four of them unbeaten, six in excess of 150. His average in the 22 Tests he has played solely as a batsman sits at an incredible 96.40.

Tuesday, December 11, 2007

Prof Martin Feldstein has written about what America should do to avert a recession. The article captures one of the major dilemmas facing policymakers worldwide - the role of monetary and fiscal policies in stimulating an economy facing recession. Let us list out the possible dangers facing the American economy today

1. Liquidity crisis arising from the bursting of the sub-prime mortgage bubble - corporate debt market drying up2. Inflation concerns arising from the weakening dollar and peak oil (this would force up interest rates, and thereby cause more home mortgage defaults) 3. Fall in consumption due to weakening of the wealth effect from asset bubbles (this is serious given that consumption formed 2.1% of the 3.9% Q3 2007 GDP growth of the US economy)4. Asian and other Central banks moving towards other more remunerative assets, thereby causing rise in interest rates and further weakening of dollar. Foreign governments and investors now hold some $2.23 trillion — or about 44% — of all publicly held U.S. debt worth $5.1 trillion. That's up 9.5% from a year earlier.5. Rising import prices as the dollar depreciates, thereby hurting consumption. 6. Rising public debt and weakening dollar puts upward pressure on interest rates. National debt touched $9 trillion in November 2007, and is growing at $1.4 bn a day! 7. All or some of the aforementioned could throw up recession, inflation and unemployment.

Prof Feldstein forecasts a 50% chance of recession in 2008. He recommends a twin strategy of loose monetary policy and fiscal stimulus to reduce the risk of recession in the coming year. He explains, "What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level."

He finds two benefits in such a stimulus, "First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process."

On monetary policy, he writes, "The current 4.5% fed-funds rate is essentially neutral - not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy. The Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement."

The rationale for lower rates are, "Lower interest rates will still reduce monthly interest payments for the one-third of homeowners who have adjustable rate mortgages, thus freeing up cash to spend on other things. When banks make new loans, they will do so at lower interest rates, encouraging more business and household borrowing."

The reasons for favoring a conditional fiscal stimulus as against a loose monetary policy are 1. The lurking dangers of inflation and a plunging dollar. 2. A loose monetary policy is likely to sustain the asset bubble or even worsen it. 3. Lowering interest rate may not yield the desired results, given the "lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices."4. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets.

But this twin track approach faces numerous objections. 1. If the recessionary expectations become substantial, the fiscal stimulus is likely to be saved in bank deposits and not productively spent. Private investment is also likely to be put off in anticipation of a recession. 2. If oil prices continue to rise and imports becomes dearer, inflationary expectations get energised. This coupled with a sliding dollar and widening public debt, will bring upward pressure on the interest rates. The Fed will have limited room to manouvre with monetary policy. 3. Just as a loose monetary policy has the potential to sustain the asset bubble and even initiate a new one, the fiscal stimulus has the potential to continue the unsustainable consumption boom. It would encourage Americans to continue living beyond their means. 4. The fiscal stimulus would further postpone facing up to the hard reality of very low household savings (negative) and high current account deficits. It would only paper over the structural distortions that have crept into the US economy over the past decade. 5. The financial system is not facing a liquidity crisis, which can be overcome by lowering rates. Significant sections of the financial markets are facing a "solvency problem", which cannot be tided over by merely relaxing the monetary policy.

The aforementioned policy prescription by Prof Feldstein would appear to be aimed at sustaining the consumption led economic growth, and not concerned at addressing the deeper problems associated with the US economy. While this strategy may help avert an immediate recession, it may fuel even more distortions and take the economy further away from any sustainable growth equilibrium. There is an immediate precedent here. In the aftermath of the tech stocks bubble, Alan Greenspan effectively pumped up the real estate and mortgage loan bubble by lowering interest rates 13 times, over a three year period to a historic low of 1% in June 2003. Another way of looking at the situation would be to see it as an opportunity to take the steam off an excessively consumption dependent and bubble based economy, which is living far beyond its limits, and prepare the ground for a soft landing. The is to be achieved without stoking off a recession.

The challenge is to use the soft landing to correct the many structural distortions. The current account deficit and trade deficit has to be brought down by a two-pronged strategy of increasing exports and decreasing imports (atleast consumption based imports). The over dependence on Chinese and other Asian Central Banks to finance deficits has to end. The solution to recession is not to simply consume more! In the final analysis, the dilemma is to make a choice between the following two choices1. Using the tools of fiscal and monetary policy to avert a recession now, while opening up the distinct possibility of sustaining and even continue building up the distortions. 2. Eliminating or atleast reducing the distortions by preparing for a soft landing. This strategy comes with uncertainty about the extent of a possible recession.

Given that both options face considerable uncertainties, and any Government intervention will be on the basis of many debatable assumptions, I am inclined to believe that it may be better to face a mild recession now, rather than prepare for a major one later!